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By HaleStewart January 23, 2015 11:22 am
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International Economic Week in Review: A Big Week For Central Banks, Edition

          This week, we saw a large amount of policy action on the part of central banks.  Let’s start with the Bank of England, where the two board members who had voted for rate increases at the last meeting were now neutral:

In the view of all members, the outlook justified maintaining both the current level of Bank Rate and the stock of asset purchases financed by the issuance of central bank reserves. It was possible that the risks to CPI inflation in the medium term might have, if anything, shifted to the upside, but all members were also alert to the downside risk of current low inflation becoming entrenched. Monetary policy could and would be adjusted at the appropriate time to ensure that CPI inflation was on track to meet the 2% target in the medium term.

For the two members who had voted in the previous month for an increase in Bank Rate, the decision this month was finely balanced. They believed that the sharp fall in inflation to below the 2% target was probably driven largely by temporary factors and was unlikely materially to affect the behaviour of households and businesses in such a way that it became self-perpetuating. They also noted the most recent evidence that wage growth was more buoyant than they had expected. Nevertheless they noted the risk that low inflation might persist for longer than the temporary factors implied and concluded that this risk would be increased by an increase in Bank Rate at the current juncture.

There is a rather interesting level of double speak in the above paragraphs.  On one hand, there is a possibility of higher inflation in the future, yet there is a strong concern that lower inflation may become entrenched in the short term.  If these seem like contradictory positions given the current global commodities sell-off, you’re not alone.  And, given the trajectory of the inflation rate, an upward spike seems a bit far-fetched:

          The accompanying minutes did note that wage pressures had been ticking up:

Annual growth in whole-economy total pay had been 1.4% in the three months to October. Private sector regular pay had grown by 2.0% over the year and at an annualised rate of 4.3% in the three months to October

However, given these were some of the first truly meaningful increases in pay, it’s difficult to attribute massive inflationary potential to them.

          Canada lowered their interest rate by 25 basis points.  In their announcement they noted:

The oil price shock increases both downside risks to the inflation profile and financial stability risks. The Bank’s policy action is intended to provide insurance against these risks, support the sectoral adjustment needed to strengthen investment and growth, and bring the Canadian economy back to full capacity and inflation to target within the projection horizon.

          The central bank explained the negative impact of oil prices on the Canadian economy in a presentation earlier this month:

Despite the mitigating factors I enumerated, lower oil prices are likely, on the whole, to be bad for Canada. Estimating the magnitude of that overall impact requires carefully analyzing the interplay between the various effects as they work through the economy. That is what we are doing as we prepare next week’s forecast.

Canada is one of the few developed countries that is dependent on natural resources and their export.  Lower oil means lower exports, investment and inflation, translating into weaker GDP growth.  This explains the underlying rationale for the rate cut.

          Brazil raised rates – again – this time by 50 basis points, bringing their overall rate to 12.25%.  Brazil is facing its own version of stagflation, with low GDP growth:

And high inflation:

And just to add to the countries difficulties, their currency is one of the worst performing over the last 6 months, largely as a result of capital flight out of developing countries.  This means Brazil is also importing inflation.  Yet, despite the fact they’re had some of the highest interest rates (their rates were 11% for all of 2014 before the more recent, inflation fighting increases), their currency continues to move lower. 

          Japan maintained their current asset purchase and interest rate programs.  However, the big news from their release was the decrease in their 2015 inflation projections:

Compared with the forecasts presented in the October 2014 Outlook for Economic Activity and Prices, the growth rate will likely be lower for fiscal 2014, but will likely be higher for fiscal 2015 and 2016. With regard to the CPI, the outlook for the underlying trend remains unchanged, but the year-on-year rate of increase will likely be lower toward fiscal 2015, due to the significant decline in crude oil prices. The rate of increase for fiscal 2016 will likely be more or less unchanged from the October forecast. 

          At this point, one has to wonder exactly what additional measures the BOJ can undertake to combat deflationary pressures.  While the bank is likely correct that the more recent effects are largely caused by the drop in oil prices and are therefore mostly temporary, there is always the possibility that prices continue to move lower in spite of an oil price increase.  And, prices were already moving lower before oil's collapse.  The bank has not highlighted this development in their releases, most probably because they also realize their policy options are becoming more and more limited.

          But most important is the news out of Europe that the ECB will (finally) engage its own version of QE.  The EU’s problems are by now well known to market participants: growth is stagnant while inflation has been decreasing, now printing negative year over year numbers in the latest reading.  Here are the totals of the program as announced:

First, it decided to launch an expanded asset purchase programme, encompassing the existing purchase programmes for asset-backed securities and covered bonds. Under this expanded programme, the combined monthly purchases of public and private sector securities will amount to €60 billion. They are intended to be carried out until end-September 2016 and will in any case be conducted until we see a sustained adjustment in the path of inflation which is consistent with our aim of achieving inflation rates below, but close to, 2% over the medium term. In March 2015 the Eurosystem will start to purchase euro-denominated investment-grade securities issued by euro area governments and agencies and European institutions in the secondary market. The purchases of securities issued by euro area governments and agencies will be based on the Eurosystem NCBs’ shares in the ECB’s capital key. Some additional eligibility criteria will be applied in the case of countries under an EU/IMF adjustment programme.  

The net effect of these purchases is the EU bond market now has a 1 trillion euro buyer in the market for the next year and a half – or until inflation is back around the 2% Y/Y rate.  This is a very important escape clause, granting the ECB a tremendous amount of policy flexibility. 

          To sum up this week’s central bank actions:

  • The Bank of England is now a bit less likely to raise interest rates as oil’s fall has given them a bit more maneuvering room regarding inflation.
  • Canada is concerned about overall growth, and they are acting accordingly.  As an aside, this may give the Bank of Australia an intellectual justification for action as well, given some of the underlying similarities between the economies
  • Brazil’s problems are deepening.  Growth is stagnant, but inflation is becoming more and more entrenched.  The central bank may have to engage in far more aggressive policy actions to finally take inflation out of the equation.
  • The BOJ is in a policy bind.  They are already flooding the market with yen, yet inflation’s Y/Y growth is clearly moving lower.  It’s logical at this point to ask if they’re at or very near the end of their viable policy responses.
  • The ECB FINALLY did something about inflation.  While the size of their policy response has caught some by surprise, the fact it took nearly a year into their deflationary experience is very concerning, and leads to the question of “is this occurring too late.” 

Hale Stewart is a former bond broker who has been writing about economics and financial markets since 2006 on the Bonddad Blog.  He is also a tax attorney with a domestic and international practice while also forming and managing captive insurance companies for US companies.   You can follow him on twitter at:@captivelawyer



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